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A complete set of financial statements includes
the income statement,
balance sheet, statement
of cash flows, footnotes,
and the accountant’s
opinion. Unless the statements are prepared by a CPA,
the opinion letter and footnotes generally are omitted and
most small companies also eliminate the statement of cash
flows.
Financial statements are prepared on either a cash
or accrual basis. A cash
basis financial statement reports only the money received
and spent. An accrual basis
financial statement reports all sales billed and not received
and all expenses incurred but not paid. The financial and
income tax reports can differ, as different rules exist for
each.
The descriptions below provide some additional information
about each component of financial statements. Many variations
in financial statement presentation exist, depending on whether
the accounting method is cash or accrual, the type of entity
(corporation, partnership, sole proprietorship, etc.), and
other factors. The explanations below are general in nature
and do not explain all these variations.
Income Statement
Also called a p&l or profit
and loss statement, the income statement reports the
income and expenses of the business for a given time period
of time. The bottom line usually is the net
profit after taxes for the period reported.
Revenue or income is shown at the beginning of the statement,
followed by any costs that specifically are related to sales
or revenue. The difference between sales and cost of sales
is called gross profit. Additional
expenses are shown as a reduction of gross profit. Taxes and
miscellaneous items of income and expense may be shown separately.
Balance Sheet
Also called the statement of assets,
liabilities and owner’s equity, the balance sheet
is a snapshot of the assets, liabilities. and equity of the
business on a specific date — the balance sheet date.
The assets of an entity are
the amount of cash, inventory, equipment, and other assets
used to generate the company’s profit or loss.
The liabilities identify what
the company owes to various creditors. The liabilities may
include trade accounts payable (unpaid bills), credit card
debts, payroll tax deposits, bank loans, or money due to the
owners. Liabilities may be identified as either short-term
or long-term. Short-term
debt is the amount that will be repaid within the next year
from the balance sheet date. The long-term
debt is the amount that will be repaid in future years or
over a time greater than one year.
The third section of the balance sheet is the equity
section. It includes the amounts the owners of the entity
have paid for common stock and contributed capital, and the
total of all profits for the current year and all years since
the entity began — this usually is called retained
earnings.
The balance sheet is used to calculate many ratios that measure
the entity’s financial health such as the number of days
it takes to collect outstanding accounts receivable, the ratio
of assets and liabilities, and many other financial statement
ratios.
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Statement of
Cash Flows
The statement of cash flows identifies how cash
came into the entity and how this cash was used. It is the
only report that ties the income statement and balance sheet
together, as information from both is used in this report.
This report explains the changes in a company’s
cash position between two balance sheet dates. The indirect
method is the most common form of cash flow presentation.
It starts with the current income or loss, then shows adjustments,
such as depreciation, that are not the result of cash transactions.
The statement will show other sources or uses of cash such
as borrowing or repaying loans, capital contributed by the
owner, and sales or purchases of equipment.
Footnotes
Footnotes usually are omitted in financial statements
of small businesses, but they are required for reviewed and
audited financial statements and sometimes are included with
year-end compilations.
The footnotes provide detailed information about
the entity’s loans, leasing commitments, accounting policies,
and other required information as defined by the American
Institute of Certified Public Accountants (AICPA). The AICPA
is the organization that defines the rules and procedures
used in issuing standard accounting reports.
Opinion
Also called the accountant’s
report, the opinion letter usually is the first page
of any financial report package prepared by a CPA. The letter
states the type of report being issued and whether material
modifications are required for the report to conform with
generally accepted accounting principles (GAAP). The three
types of financial statements are compilation,
review, and audit.
All opinions tell the reader the information
represents the entity’s management. Thus, the purpose
of the report is not to detect fraud, but rather to follow
the guidelines issued by the AICPA for the opinion or confidence
level required
A compilation
takes the accounting information provided by the company and
presents the information in the form of financial statements.
The compilation report tells the reader if management has
omitted footnotes, or if the reader should know other information,
such as a lack of independence. It provides the least amount
of assurance that the financial statements are free from material
misstatements, but is the most cost-effective for management.
The financial statement report may need to be changed to a
review or audit if required by a bank or other third-party
user of the financial statements.
The review takes
the accounting information of the business and presents it
in the form of financial statements with the required footnotes
and disclosures. Some inquiries of management and limited
analytical procedures are applied. A review report contains
the same information as an audited report, but is less costly
than an audit because many audit procedures are not required.
An audit report
is in the same format as a review. To provide an audited opinion,
the CPA must test the integrity of the entity’s internal
control systems and perform additional procedures to determine
whether the financial statements are free from material misstatements.
Audit procedures include confirmation of data from outside
sources such as financial institutions, customers, vendors,
and other sources involved with the entity. Full footnote
disclosure is required and the CPA issues an opinion on the
financial statements, which must be presented according to
generally accepted accounting procedures (GAAP).
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